Weekly Thoughts: Rule of 40
Here is something that caught our eye this week:
Rule of 40
The central tenant of Chenmark’s investment thesis is to acquire small operating companies with steady — but not necessarily high — growth rates coupled with a long history of profitability, and an enduring, defensible competitive position. As is fairly common in the broader private equity space, we typically center internal valuation discussions around a multiple of EBITDA, although that is really a shortcut way to frame our primary goal of optimizing for long-term cash-on-cash returns.
We acknowledge that other investors utilize different mental models when it comes to thinking about valuation, and we are always interested to learn more about how that thinking might (or should) differ from our own approach. Perhaps the most polar opposite mental framework for valuation exists in venture capital where growth, scale, and market opportunity replace our focus on operating margins, capital intensity, and customer stickiness. Prominent VC investor, Fred Wilson, highlighted this point in a recent blog post by noting, “the startup and venture capital businesses are based on a general idea that you can and should invest heavily into your business in order to increase value creation, amplify it, and accelerate it. These investments mostly take the form of operating losses, driven by headcount, where the monthly expenses are larger, often much larger, than revenues.”
Rather than viewing intrinsic value as increasing in tandem with EBITDA, startup investors focus on top-line growth (and potentially even the second derivation thereof) as its primary driver. Despite a comfort with growth over profit, intelligent investors still have to spend at least some time thinking about the cost of that growth. On this note, we stumbled across an elegantly simple mental model dubbed the “Rule of 40”. Investor Brad Feld explains the rule in his blog:
“The 40% rule is that your growth rate + your profit should add up to 40%. So, if you are growing at 20%, you should be generating a profit of 20%. If you are growing at 40%, you should be generating a 0% profit. If you are growing at 50%, you can lose 10%. If you are doing better than the 40% rule, that’s awesome.”
Practically speaking, it really may be that simple as a recent River Cities Capital report on the valuation of 92 SaaS companies confirmed that, on average, those in line with the Rule of 40 realized higher valuations, as demonstrated in the chart below:
While the Rule of 40 is often referenced when evaluating SaaS companies, it has applications to any business where there is a direct relationship between revenue and value creation. On this point, Fred Wilson deconstructed the Rule of 40 into a more broadly applicable framework for burn rate evaluation, arguing that annual value creation should be at least 3-5x the amount of cash burned over the course of the year. A growing company losing $6-10 million in a year, for example, should expect to generate an increase in valuation of $30 million. From the investor standpoint, this can be an attractive (and lucrative) value proposition assuming the company is able to realize its presumed valuation increase (a conversation for another Weekly Thoughts).
Ultimately, investors are willing to accept operating losses because they are deploying capital into business opportunities where they believe in the potential achievement of a dominant position in a large market. The thought is that the future profit associated with such scale will far outweigh the capital burned in the early years. While Chenmark is focused on investing in companies that are optimizing operations in an already defined market and generating comfortable profits, we enjoy reading about other frameworks because it forces us to stress test our own target mix of revenue growth, profitability, and capital reinvestment. All our portfolio companies and Chenmark itself have opportunities to grow and we must ensure we are reinvesting thoughtfully at a level necessary to support that growth, even if it is unlikely to result in a 6x revenue valuation.
Have a great week,
Your Chenmark Capital Team